New Benchmark Will Likely Succeed Over Time, Give China More Market Power

China’s futures contract, along with bolstering the yuan, is one part of an extensive strategy to increase the country’s power in the international oil market and global economy.

In the early 1980s, when the NYMEX crude futures contract was being established, major oil companies did not see it as a credible trading tool, and one executive mocked the new benchmark “as a way for dentists to lose money,” according to historian Daniel Yergin. Perceptions quickly changed, and the NYMEX crude futures market has been a largely successful trading arena where producers, commodity merchants, consumers, and speculators all participate in a highly profitable and liquid commodities trading.

To be sure, the NYMEX crude benchmark has taken decades for it to thrive at today’s levels with volumes of almost 1.5 million contracts traded per day. And it has come under heavy criticisms over the years for the outsized influence of hedge funds and other speculators, and its pricing point being land-locked Cushing, Oklahoma. But even as the United States’ most cited crude oil price has experienced a number of setbacks over the years, any successful futures contract—whether in petroleum or any other commodity—takes time, with many projects even failing, including China’s attempt to establish a petroleum exchange in the 1990s.

It’s important to understand the initial skepticism of the NYMEX contract and its evolution over the past 35 years when looking at this week’s launch of China’s crude oil futures contract. The Shanghai oil exchange, which opened on Monday, has started trading oil in renminbi, China’s official currency. Some analysts are doubtful that it will find the success Beijing seeks. “Even if Chinese oil futures became the most liquid crude contracts in the world, they would be tied to the deeply illiquid offshore renminbi,” wrote David Fickling in Bloomberg Gadfly. “Yuan-denominated oil is seen as a crucial part of internationalizing the renminbi as a global currency, but that goal can never really be attained while Beijing insists on maintaining current levels of control over its capital account. Until that changes, [ICE] Brent and [NYMEX] WTI will continue to rule this roost.”

The balance of power in the global oil market is clearly shifting east.

Beijing’s motivations for establishing the benchmark are complex, with economic, domestic, and geopolitical considerations taken into account. Its decision not only supports domestic oil players, but also strengthens its status internationally. With this being the case, China’s drive for the contract to flourish will be persistent, giving it a greater chance of long-term success. The fact that it was launched despite the number of delays, bureaucratic infighting, controversies over which crudes to include, and simple logistics such as trading hours reflects how important the benchmark is to the country’s global economic and geopolitical ambitions. The futures contract, along with bolstering the yuan, is one part of an extensive strategy to increase its power in the international oil market and global economy. Since it will take China years, perhaps decades, to fully realize its ambitions, Beijing will continue to play the long game, and for now, it is effectively making progress.

The balance of power in the global oil market is clearly shifting east. China is still seeing the largest oil demand growth volume-wise, and it is now the largest net importer of crude oil, surpassing the U.S. on an annualized basis in the second part of 2016.

Even though the U.S. still consumes more than China and shale production continues to rise, the Asia-Pacific nation’s clout in the oil market will keep increasing because of growing imports.

Even though the U.S. still consumes more than China and shale production continues to rise, the Asia-Pacific nation’s clout in the oil market will keep increasing because of growing imports, its deals with oil-producing countries, and the launch of the benchmark. China’s rise mirrors the United States’ dominant role in the 1980s with the launch of the NYMEX and its rapid rise in consumption while domestic production was falling. China’s increased consumption, and stockpiling for its strategic reserves, has been a major factor supporting oil prices over the past decade and a half. This trend will continue for the foreseeable future, and Beijing wants to take advantage of the fact that its market power is rising. Its state actors, including its large oil companies, can distort global oil prices through their dominance in oil trading east of the Suez Canal. PetroChina and Sinopec have distorted oil prices in the Dubai benchmark (assessed by Platts) for years and will likely continue to do so in the new yuan-denominated contract, given their size and influence.

Benchmark’s successful debut

The benchmark saw a strong opening on Monday with international participants and total traded volume for the September contract beating expectations with the equivalent of almost 20 million barrels. The contract’s settlement was the equivalent of about $68.70 per barrel, about $3 per barrel above Mideast crudes, a positive sign for potential arbitrage opportunities. Capital controls, the contract’s volatility, and the currency issue will be key factors that may inhibit participation and for it to become a legitimate source for Middle Eastern term pricing.

Some market watchers are optimistic about the contract’s potential. “The contracts are not only a hedging tool for businesses but an important element in the national economy given the significance of the commodity,” said Jiang Mingde, chief strategist at Yixinweiye Fund Management.

The more success the benchmark has, the more China’s influence on the global oil market will grow and achieve its goal of challenging the dollar’s hegemony.

The more success the benchmark has, the more China’s influence on the global oil market will grow and achieve its goal of challenging the dollar’s hegemony. Now that demand growth is overwhelmingly taking place in emerging markets, with China out in front, the global oil market is becoming less U.S.-centric. China will not upend the dollar system or replace NYMEX or ICE Brent futures overnight, but advancing its currency is one considerably substantial step toward attaining China’s geopolitical goal of undermining the unipolar power of the U.S.

Stay Informed

Subscribe to our newsletter today!

The Fuse is an energy news and analysis site supported by Securing America’s Future Energy. The views expressed here are those of individual contributors and do not necessarily represent the views of the organization.

Issues in Focus

Safety Standards for Crude-By-Rail Shipments

A series of accidents in North America in recent years have raised concerns regarding rail shipments of crude oil. Fatal accidents in Lynchburg, Virginia, Lac-Megantic, Quebec, Fayette County, West Virginia, and (most recently) Culbertson, Montana have prompted public outcry and regulatory scrutiny.

2014 saw an all-time record of 144 oil train incidents in the U.S.—up from just one in 2009—causing a total of more than $7 million in damage.

The spate of crude-by-rail accidents has emerged from the confluence of three factors. First is the massive increase in oil movements by rail, which has increased more than three-fold since 2010. Second is the inadequate safety features of DOT-111 cars, particularly those constructed prior to 2011, which account for roughly 70 percent of tank cars on U.S. railroads. Third is the high volatility of oil produced from the Bakken and other shale formations, which makes this crude more prone towards combustion.

Of these three, rail car safety standards is the factor over which regulators can exert the most control. After months of regulatory review, on May 1, 2015, the White House and the Department of Transportation unveiled the new safety standards. The announcement also coincided with new tank car standards in Canada—a critical move, since many crude by rail shipments cross the U.S.-Canadian border. In the words DOT, the new rule:

Since the rule was announced, Republicans in Congress sought to roll back the provision calling for an advanced breaking system, following concerns from the rail industry that such an upgrade would be unnecessary and could cost billions of dollars. The advanced braking systems are required to be in place by 2021.

Democrats in Congress have argued that the new rules are insufficient to mitigate the danger. Senator Maria Cantwell (D-WA) and Senator Tammy Baldwin (D-WI) both issued statements arguing that the rules were insufficient and the timelines for safety improvements were too long.

The current industry standard car, the CPC-1232, came into usage in October 2011. These cars have half inch thick shells (marginally thicker than the DOT-111 7/16 inch shells) and advanced valves that are more resilient in the event of an accident. However, these newer cars were involved in the derailments and explosions in Virginia and West Virginia within the past year, raising questions about the validity of replacing only the DOT-111s manufactured before 2011.

Before the rule was finalized, early reports indicated that the rule submitted to the White House by the Department of Transportation has proposed a two-stage phase-out of the current fleet of railcars, focusing first on the pre-2011 cars, then the current standard CPC-1232 cars. In the final rule, DOT mandated a more aggressive timeline for retrofitting the CPC-1232 cars, imposing a deadline of April 1, 2020 for non-jacketed cars.

Oops!

We weren't able to sign you up for our newsletter.Please check your email address and try again.

DataSpotlight

The recent oil production boom in the United States, while astounding, has created a misleading narrative that the United States is no longer dependent on oil imports. Reports of surging domestic production, calls for relaxation of the crude oil export ban, labels of “Saudi America,” and the recent collapse in oil prices have created a perception that the United States has more oil than it knows what to do with.

This view is misguided. While some forecasts project that the United States could become a self-sufficient oil producer within the next decade, this remains a distant prospect. According to the April 2015 Short Term Energy Outlook, total U.S. crude oil production averaged an estimated 9.3 million barrels per day in March, while total oil demand in the country is over 19 million barrels per day.

This graphic helps illustrate the regional variations in crude oil supply and demand. North America, Europe, and Asia all run significant production deficits, with the Middle East, Africa, Latin America, and Former Soviet Union are global engines of crude oil supply.